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Are Hedge Funds Worth The Money? Depends On Who You Ask

The June 1-2 weekend Wall Street Journal ran an opinion piece proclaiming that no one can say “the basic logic of investing in hedge funds is flawed.”[1] The very same edition carried this headline: “The Verdict Is In: Hedge Funds Aren’t Worth the Money.”[2]

How should investors react to such blatantly contradictory bits of advice from the same esteemed publication?

Bob Rice, managing partner of Tangent Capital, bases his pro-hedge-fund case on the downside protection inherent in a long/short strategy.

Naysayer Mark Hulbert, editor of The Hulbert Financial Digest, acknowledges that the Dow Jones Credit Suisse Hedge Fund index went down far less during the 2007-2009 bear market than the Wilshire 5000 Total Market Index. He points out, however, that hedge funds have slightly underperformed stocks since the October 2007 bull market peak.

Moreover, hedge funds had a built-in advantage because many of them play in non-equity asset classes that have done far better than stocks since October 2007.

Rice chooses a different performance measurement period, namely, the past 30 years. Over that interval, he claims, the long/short approach “has returned about five times as much as the indexes have for every dollar invested.”

Rice provides no source for this statistic, but related information appears in his recently published book, The Alternative Answer. Page 103 contains a graph produced by Altegris, an advisor to alternative strategy mutual funds. It shows “long/short equity” (not identified as a specific group of funds) appreciating 2.5 times as much as “U.S. stocks” over the past 22 year. The accompanying text does not deal with potential statistical snares, such as survivor bias.

Citing research by David Hsieh of Duke University, Hulbert reports that only 20% of hedge funds have outperformed equivalent-risk portfolios composed of index funds and “other widely available investments.” Rice acknowledges that to beat the stock averages, an investor must buy a superior hedge fund, rather than an average performer. He is either unaware of, or declines to deal with, a crucial finding of Professor Hsieh, namely that it is nearly impossible to identify the superior performers in advance.

Rice concedes that average managers do not deserve the high fees typically charged by hedge funds, but argues that the very best do. He likens them to Hollywood superstars, noting that Meryl Streep can name her price for accepting a role. This is an unfortunate analogy, because research by Avri Ravid of Yeshiva University and others[3] finds that even the biggest-name film actors fail to deliver a big enough box-office boost to justify their multi-million-dollar fees.

Hulbert does not address the popularity argument, so let me do so. My advice is to remember what your mother said when you wanted to do something unwise because “everyone” was doing it: “If everyone jumps off a cliff, will you do that, too?”

The arguments offered by Rice and Hulbert meet obliquely, rather than head-on. It is therefore difficult to pick a winner in their virtual debate. Nonetheless, an important lesson emerges from the coincidence of their pieces appearing on the same day: Before acting on financial advice published in a newspaper, get the full story by reading another article that makes the opposite case.

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